He was hailed as the “greatest businessman alive,” with admiring cover-picture profiles in Time and Fortune magazines. His company, a huge diversified business built up by both acquisition and internal growth, had 44 consecutive quarters of increasing earnings, with sales increasing by 30-fold.
His remuneration was notably high, but was defended because of the shareholder value he had created. He was believed to have invented a new methodology for managing large corporations, and his every saying was monitored for hints as to how lesser mortals might manage better.
No, the year was not 2000, and the manager was not “Neutron Jack” Welch of General Electric; the year was 1969, and the manager was Harold Geneen, president and CEO of ITT Corporation, a position he held for eighteen years (1959-77).
Geneen is remembered today as the ultimate bean-counter, a man who managed by the numbers, sacrificing profitability for sales growth, acquiring almost at random (twenty companies in one month), with no overall strategic vision “I never met a business I didn’t find interesting”, he once said.
Yet at his peak he was regarded very much as Jack Welch is seen now, as the epitome of the dynamic, successful top manager. His style too, was not all that different to Welch’s, with Geneen once saying “You can know a person by the kind of desk he keeps. If the president of a company has a clean desk, then it must be the executive vice president who is doing all the work.”
Geneen died in 1999 at the age of 87, and ITT, as was well recorded at the time but is now fading from the memory, descended through political funding scandal (Nixon, 1972) through sponsorship of foreign coups (Pinochet, 1973), through decades of earnings disappointment, losses, and eventual break-up by Geneen’s successor in 1995.
ITT stock peaked in 1969, and brought investors negative returns from then until the mid 90’s.
Welch’s defenders would claim that his management style differs completely from Geneen’s. Welch sponsored entrepreneurship (“we cultivate a hatred of bureaucracy … bureaucrats must be ridiculed and removed.” — GE Annual Report, 2000.)
Geneen sponsored bureaucracy, with ITT notoriously having the most complex financial reporting system of its time, and Geneen himself being famous for his ability to spot a single discrepancy in a financial report hundreds of pages long.
Of course GE, too, is a leader in corporate adoption of the Internet supply chain, surely today’s equivalent of 1969’s computerized accounting system.
Yet how much of this is simply the evolution of management buzz-words over a period of 30 years?
How entrepreneurial can you be, after all, in a company with 134,000 pension-eligible employees? To discover, it is worth looking a little more closely at GE itself, and at Welch’s 19-year record as CEO, at a point when his latest deal, the Honeywell takeover, teeters on the brink of failure.
When Welch took over GE in 1982, it was a conglomerate, but one largely confined to engineering businesses. Welch famously announced that he would neither acquire nor retain any business that was not No. 1 or 2 in its market, in terms of market share, and that he would be ruthless in cutting staffing levels and reducing bureaucracy — hence his nickname “Neutron Jack” from the bomb that eliminated people but did not damage buildings.
Over the years, there have been a number of well-known successes, such as medical equipment, but there have also been a number of embarrassing failures, such as the broadcasting network NBC, which was in a business that was already declining in 1986 when GE bought it.
Most embarrassing perhaps, was GE’s 1986 acquisition of Kidder Peabody, an investment bank with a successful 100-year history, that needed an infusion of capital but was nowhere near No. 1 or 2 in the business, by any measure. After replacing Kidders’ capable top management with Sy Cathcart, former CEO of Illinois Tool, a personnel choice that prompted the quip among Kidder employees that “what every investment bank needs is a good tool and die man,” GE then ran Kidders with total disregard for its highly specialized corporate culture.
Consequently by 1993, when in a bizarre prequel of the Barings fiasco, the young, under-qualified trader Joseph Jett was found to have accumulated unexpected losses of $300 million, nobody was surprised, as more or less the entire long-service Kidder top and middle management cadre had by then succumbed to outside job offers, retirement or the unemployment line in preference to working for GE.
GE then took the obvious step of closing down Kidders, thus proving definitively that there were businesses that were not amenable to the Welch methods, even in what was for almost every other participant the middle of a roaring bull market for investment banking services.
Today, GE is a very different company from 1982. In particular, GE Capital Services, GE’s financial services arm, accounted in 2000 for 51 percent of the group’s operating revenues, 41 percent of net earnings, and no less than 85 percent of GE’s total assets. At least half the group, therefore, should presumably trade around Citigroup’s price/earnings ratio of 19 times earnings, rather than GE’s level of 37.3 times, since it is in the same business as Citigroup, though GE Capital Services is less well established and presumably therefore has less “franchise” value.
However, GE’s 2000 earnings, like those of most companies after an 18-year bull market in which accounting standards have become progressively more lax, had a considerable amount of “water” in them, earnings that did not reflect true returns from GE’s operations.
First, GE’s pension plan earned excellent investment returns during the year. Many companies, whose pension funds earn more than they are actuarially committed to pay out, pay a zero pension fund contribution in the year. GE goes further; it pays a negative pension fund contribution, extracting money from the funds set aside to pay pensions for its workforce; in 2000 to the extent of a net $1,266 million, all of which was reported as ordinary income.
Second, GE Capital Services owns a substantial portfolio of private equity investments which, as with most such portfolios, can be sold in good years to produce gains, which are by GE taken as ordinary income. Realized gains on such investments, net of losses, appear to have been $2,799 million in 2000. Unrealized losses on such securities, on the other hand, are transferred straight to stockholders equity without going through the income statement; these totaled $552 million in 2000.
Third, in 2000 GE executives exercised options on 44.8 million shares, at an average net gain of $44.18 per share, thus transferring $1,979 million of wealth from stockholders to employees, without such wealth transfer being reported in any way in GE’s income statements.
On Dec. 31, 2000, options on a further 204.6 million shares were exercisable, at an average exercise price of $11.35 per share, compared with Monday’s closing price of $49, for a further immediate potential dilution of stockholder value of $7.7 billion.
Taking account of the three factors above then, even without any other “special” accounting treatments which I have failed to spot, GE’s 2000 pretax profits should, for long term comparability, be reduced by $6,596 million, from $18,446 million to $11,850 million. What is more alarming, its net income should be reduced by the same amount because each of these adjustments is independent of GE’s tax calculation. This reduces GE’s net income from $12,735 million to $6,139 million, a reduction of 51.8 percent.
Taking a 30 times price/earnings ratio for GE’s engineering businesses, and a 19 times price/earnings ratio for its financial businesses, and allowing earnings of $5,620 million for the engineering businesses and $599 million for the financial businesses (through allocating the above reductions appropriately between the businesses), reduces GE’s market capitalization from its Monday close of $484 billion to $178.5 billion.
Gosh, GE isn’t the largest-cap company in the US any more! Maybe Neutron Jack isn’t No. 1 either!
In summary, therefore, Neutron Jack’s is a “bubble reputation,” built through success in an 18-year bull market, reinforced like Geneen’s success in the 1960’s by heavy use of “creative” accounting. It is most unlikely to survive the next economic downturn.
One’s sympathy goes out to Jeffrey Immelt, his designated successor, who appears destined to be GE’s Rand Araskog, the man who attracted undeserved obloquy by being Geneen’s unhappy and unsuccessful successor at ITT.
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.